MODULE 3: SOURCES OF FUNDS

Finance has long been considered by Small and Medium Enterprises (SMEs) operators as an
important issue. Obtaining financial resources assistance and when they are needed can be more
difficult for small scale entrepreneurial ventures than for established organizations. The critical
issue is to ensure that sufficient cash is available for current operations and growth of the
business. The owner must also ensure that money is available to settle current liabilities when
due; these may include inventory, rent, telephone bills, office supplies etc. Other reasons
for sourcing business finance include the following:

i. upgrading facilities to comply with stricter environmental regulations

ii. financing production in cases where there is significant lag between when
costs
are incurred and when payments are received;
iii. purchasing of new equipment or facilities;
iv. purchasing of business vehicles; and
v. building up inventory in advance of a busy season.

Irrespective of the reason(s) for which funds are required, it is the sole responsibility of the
business owner to ensure that funding is obtained at the right time, at the right cost and from the
right source. Before raising the required funds, the business owner must estimate the actual
funds needed in order to avoid encountering unnecessary high cost of capital or excess capital.

SOURCES OF FUNDS FOR NEW AND ENTREPRENEURIAL VENTURES

There are several sources of finance for both new and old entrepreneurial ventures. These
sources are:
(i) Personal Savings
(ii) Borrowing from Friends and Relations
(iii) Trade Credit
(iv) Accrual Accounts
(v) Retained Earnings

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(vi) Equity Financing
(vii) Bank Loans
(viii) Project Financing
(ix) Venture Capital
(x) Debt Financing
(xi) Commercial Draft
(xii) Banker’s Acceptance
(xiii) Bills Discounting
(xiv) Commercial Paper
(xv) Inventory Financing
(xvi) Bank Overdraft
(xvii) Loans from Corporative Societies
(xviii) Hire Purchase
(xix) Leasing
(xx) Factoring
(xxi) Microfinance Bank
(xxii) Public Offerings
(xxiii) Small Business Investment Organizations

(i) Personal Savings

Personal savings is the most common source of financing for small business enterprises. It has
to do with the personal money which the entrepreneur has been able to set aside for an intended
business venture. This includes cash and any personal assets convertible into cash or to business
use, for example, cash from family/friends which is an informal form of financing falls into this
category. This may also be from past savings, trust accounts or some other form of personal
equity of the business owner. This is the least expensive method of financing and also the easiest
as the decision to lend is made by the same persons wishing to borrow the fund.

(ii) Borrowing from Friends and Relations

Funds can be raised for entrepreneurial ventures through borrowing from friends and relations.
The amount to be raised through this source however, depends on the financial capabilities of the

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friends and relations and the relationship that exists between the business owner and his friends
or relations. The repayment period and the interest payable are a function of the terms of
borrowing which are usually determined by the lender.

(iii) Trade Credit

Trade credit as a source of fund occurs when a buyer makes an arrangement with the seller to
buy goods on credit and pay later. However, this arrangement depends on the customer’s good
reputation and it often requires a pre-arrangement between the buyer and the seller. Trade credit
is one of the most widely used short term sources of funds and the term normally falls within the
range of thirty to ninety days which can still be extended after the expiration period, depending
on the relationship between the parties involved.

(iv) Accrual Accounts

Accrual accounts can also be called account payable. It represents the continually occurring
current liability of a particular business. These include wages, interest, taxes and other expenses
that are payable in arrears. They are due but yet to be paid. Their repayment period is usually
within a period of one year.

(v) Retained Earnings

Funds can also be obtained through undistributed profits. A business owner may decide
to reinvest part of his or her profit back to business for efficient operations of the business. This
is also called plough-back profit and it shows the naira value of ownership rights that result from
the business retention of its past income. In business, retained earnings are usually considered as
an additional fund for financing the future growth of the business. Retained earnings are helpful
as a last resort in business finance. The inability of the business owners in meeting up with the
stringent conditions of the financial institutions usually makes the business owner come to fall
back to their business reserves for funds raising.

(vi) Equity Financing

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Equity finance is a form of business finance in which funds borrowed to operate a business
venture are not taken as loan but converted to equity (stake in ownership) which now makes the
lender a part owner of the business venture, risk and profit are shared together. The amount of
equity finance in a particular business may be substantial subject to factors such as the nature of
the business, the total amount of capital required and the interest of the investor. The advantage
of equity financing is that its infusion of capital does not have to be repaid like a loan.

(vii) Bank Loan

A small business entrepreneur can approach bank for a loan. This is a common practice among
established small business enterprises with good reputation doing business with a particular
bank. The bank interest rate depends on the type of loan involved whether is fixed or variable.
Bank loan can be given either on short term or long term basis. Short term bank loan usually
covers between one month and less than one year, while long term bank loan covers a period that
is more than year one. The relationship of the borrower with the bank matters a lot. The reason
for this is that banks are more likely to give loans to business owners they know very well and
whom they have their business and personal records. The amount of money that banks are
willing to give per time depends on the nature of business, the size of business, the repayment
period and the creditworthiness of the business owner.

(viii) Project Financing

Project financing is the funding of a particular project by a financial institution. This can be a
source of funds only when the proceeds from the project are sufficient to repay the capital sum
usually known as the principal which is the amount of money borrowed for the execution of the
project with interest accrued. The project will be used as the security for such loan and the
advance is self–liquidating. In this case, the borrower‘s financial standing or position is less
important because the institution must ascertain the value of the project and ensure that the value
is high enough to settle the amount of money borrowed by the contractor.

(ix) Venture Capital

Venture capital is the money invested by individuals or venture capital firms in small and high
risk business enterprises. Venture capitalists are investors that invest in other people’s businesses

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for the sole aim of profit. They receive equity participation i.e. the equity ownership right of
some proportion in the business enterprises they have invested their money in. They participate
substantially in the management of the enterprises in which they have invested, holding board
positions and working in close liaison with the enterprise’s management team. The venture
capital industry may consist of:
(a) wealthy individuals
(b) foreign investors
(c) private investment funds
(d) pension funds or
(e) major corporations.

(x) Debt Financing

These are funds that the business owner borrows and must repay with interest. Borrowed capital
maintains ownership of the business (unlike equity financing, which dilutes ownership) but is
carried as a liability on Balance Sheet. In general, small businesses are required to pay more
interest than large businesses because of perceived higher risks, that is, few percent above prime
rate. Entrepreneurs seeking debt capital can have access to a range of credit options varying in
Complexity, availability and flexibility, both from commercial and government sponsored
lenders.

(xi) Commercial Draft

Commercial draft is a short term financing source credit. It is an unconditional order in writing
made by one party. The drawer addressed to a second party, the drawee ordering the drawee to
pay a specified sum of money to a third party called the payee. Commercial draft may be a sight
or time draft. The type depends on the negotiation terms.

(xii) Banker’s Acceptance

This is credit facility that involves a bank and its customer. It is a time draft payable at a
stipulated date. It is an arrangement between the businessmen who produce goods for sale. The
businessman customer then draws the acceptance credit paper requiring his banker to accept the
responsibility of settling the bills pending when the goods will be sold. By placing its acceptance

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on the bill (acceptance credit) the bank has accepted a contingent liability as well as giving an
indication that it will honour the bill upon presentation at maturity in case the customer defaults.
A discount house usually evaluates the creditworthiness and reputation of the accepting bank.
The maturity date is usually less than six months and it is mainly used in international trade.

(xii) Bills Discounting

Bills discounting is a source of finance where the supplier of goods (creditor) writes a bill of
exchange for the customer for acceptance. Immediate cash may be obtained by the supplier for
his goods after the goods have been dispatched to the customer by discounting the bill with the
bank or discount house after the bill has been accepted by the debtor (customer). Other aspects of
bill discounting involves Government securities such as Treasury Bills and certificates which can
be surrendered before their maturity dates to banks or discount houses for purchase. The amount
paid to the bill owner is less than face value.

(xiii) Commercial Paper

This is an instrument of the money market (commercial Bank) that is usually used by many
organisations to raise short- term funds. Under this source of funds, an issuing house issues it on
behalf of a company. The issuing house only finds investors to buy the commercial paper, the
investors deal directly with the company issuing the note. The issuing house does not even
guarantee the note. The issuing house charges commission for the service through a coupon rate
which is usually stated on the commercial paper. The maturity date of a commercial paper
ranges between 90 and 180 days and it is usually written out to contain details such as the date of
issue, the maturity date, the amount per coupon, etc. The coupon rate and the issuing house
commission make up the cost of commercial paper.

(xiv) Bank Overdraft

Another financial facility is an overdraft facility, which banks give to its business clients. Bank
overdraft is an overdrawn bank current account and a short-term financial facility which is
renegotiated every year depending on the performance of the business. Bank overdraft is
usually covered by personal guarantee of SME owners and carries a higher interest rate than a
normal loan. Often this interest rate is higher than profit margin percentages, which makes it a

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very short-term loan for covering cash flow problems rather than to finance acquisitions or buy
stocks. Before banks grant overdraft, the following factors are considered:
(i) The purpose for which the fund is required;
(ii) The character of the entrepreneur;
(iii) The management and financial position of the business;
(iv) The capacity of the business and
(v) Collateral security (this depends on the amount of money involved).
(xv) Inventory Financing: Inventory financing is the use of inventory or stocks as collateral
security for borrowing of fund.

(xvi) Borrowing from Cooperative Societies

A cooperative society is an association established by group of individuals who pooled their
resources together to engage in a business transaction for profit making but mainly for the
benefit of members. Depending on the financial capability of the cooperative society, it can
provide funds for its members to start business or finance their business transactions. The
amount that can be raised from cooperative society is subject to the financial commitment of the
members, the repayment period is not usually beyond two years since the fund is provided on
short-term sources of finance. The interest charged is also considerable low compared with
Commercial bank interest rates.

(xvii) Hire Purchase

Hire purchase is used when purchasing assets such as plant, equipment, machinery and vehicles.
An initial deposit may be required followed by a series of installment payment with an attached
interest. The interest rate is usually controlled by the prevailing bank rate (e.g. 4 percent above
bank lending rate when regulated by government). Under hire purchase, agreement periods can
range between 1 to 3 years depending on life span of the asset. Hire purchase is quick and easy to
arrange, the security for agreement being the asset itself. Upon the payment of the initial deposit,
the customer enjoys immediate use of the asset. The asset legally belongs to the owner of the
asset and if the buyer defaults, the owner of the assets automatically repossesses his or her asset.

(xviii) Leasing

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A lease is an agreement whereby the owner-manager (lessee) undertakes to make regular
monthly payments to the financial institution (lessor) in return for the use of equipment
belonging legally to the latter. The leasing instrument is used by SMEs to finance equipment
(including vehicles) acquisitions. Operating leases function in such a way that the leasing
company retains ownership and risks associated with the equipment (although insurance is
mandatory). The lessor is therefore both the financier and the legal owner of the equipment. In
lease financing, the following points are important and worth noting by any entrepreneur
that wants to enter into lease agreement.
(i) Ownership of the asset does not rest with the business until the asset is sold
at
residual value at end of contract.
(ii) Capital allowances may be claimed by leasing institution but not by the business.
(iii) Lease payments are tax deductible that is, passed as expenses in Profit and Loss.
(iv) Leasing does not normally affect borrowing capacity unless financial
legislation
requires balance sheets to reflect leasing finance.
(v) Period of repayment matches expected life of asset.
(vi)Immediate use of asset.

(xix) Factoring
Factoring is a financing source that allows a business owner to raise fund based on the value of
his or her invoices yet to be paid. Under factoring arrangement, an entrepreneur can outsource
their sales ledger operations and maximize the use of sophisticated credit rating systems for their
funding. Factoring arrangement can be with or without recourse. It is with recourse if the factor
company collects the amount due from other means upon the default of the debtor and without
recourse, if the factor company bears the consequence upon default of the debtor.

(xx) Microfinance Banks

The establishment of microfinance banks is meant to expand the financial infrastructure of the
country so as to meet the financial requirements of the Micro, Small and Medium Enterprises
(MSMEs).

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(xxi) Public Offerings
Public offering is a financing option that is only available to companies that are well established.
Businesses with sustainable growth potentials in the course of expanding their businesses might
decide to use public offerings by ‘going public’ to raise required funds for their business
operations. Public offering usually starts with selling of equity holding to the public and this is
called initial public offering (IPO) in which stock is registered with the Securities and Exchange
Commission (SEC). This is usually offered to the public through a registered Brokerage firm or
an investment Banker and this gives the organization the opportunity to trade its shares in the
floor of the stock exchange market. Public offerings usually result in long term sources of funds
which include the following:
(a) ordinary shares
(b) preference shares
(c) debentures

(xxii) Small Business Investment Organizations. These can be government owned or private
owned with debts being government guaranteed. Small business investment organizations can be
regular or specialized, for example, giving loans only to agro-business or manufacturing
firms, business research, product research and development, business start-ups and
minority/vulnerable groups. Unlike traditional venture capital companies, they use private funds
or government funds to provide both for debt and equity financing to small businesses.
Examples of institutions under this category are – Small and Medium Industries Equity
Investment Scheme (SMIEIS), Central Bank of Nigeria (CBN, National Economic
Reconstruction Fund (NERFUND), National Bank for Commerce and Industry (NBCI), Small
Scale Industries Credit Scheme (SSICS).

INTERNAL AND EXTERNAL SOURCES OF FUNDS

Internal financing is the term for a firm using its profits as a source of capital for new
investment, rather than distributing them to firm's owners or other investors and obtaining capital
elsewhere while external financing consists of new money from outside of the firm brought in

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for investment. External financing is generally thought to be more expensive than internal
financing, because the firm often has to pay a transaction cost to obtain it. Internal financing is
generally thought to be less expensive for the firm than external financing because the firm does
not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with
paying dividends.

Advantages and Disadvantages of internal financing

Advantages of internal sources of finance include the following:

i. capital is immediately available;
ii there is no interest payable on such fund;
iii. there is no control procedures regarding the credit worthiness of the owners; and
iv there is no third party’s influence.

Disadvantages of internally sourced funds

i. It is somehow expensive.
ii. It does not easily increase capital.
iii. It is not as flexible as external financing.
iv. It is not tax-deductible.
v. It is limited in volume because it is subject to the capability of the owner(s) to raise fund
internally.

FORMAL AND INFORMAL SOURCES OF FUNDS

Formal sources of funds represent those institutions that are registered with appropriate
authorities to transact the business of finance with entrepreneurs. Examples of formal sources of
funds include loans from commercial banks, insurance company etc. Formal financial services
are usually provided by financial institutions that are controlled by the government and subject to
banking regulations and supervision. On the other hand, informal sources of funds are provided
outside the structure of government regulations and supervision. Examples of informal sources

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of funds include those groups or individuals that are involved in loan disbursement with little or
no formal regulations e.g. Esusu, thrift savings scheme, cooperative society etc.

Advantages of formal sources of finance

(i) Provides proper guidelines and documentation for loans.
(ii) Business advisory support from the banks that is lending.
(iii) Helps the entrepreneur to stay focused on the business because of interest rates.

Advantages of informal sources of finance

(i) It helps entrepreneurs to have easy access to funding.
(ii) Less documentation is involved in loan process.
(iii) Entrepreneurs do not stand the risk of loss of assets or business to the institution.

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